1. Chapter 3: Consumer Behavior 1 of 37 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. COST-OF-LIVING INDEXES 3.6 Ideal Cost-of-Living Index ● cost-of-living index Ratio of the present cost of a typical bundle of consumer goods and services compared with the cost during a base period. ● ideal cost-of-living index Cost of attaining a given level of utility at current prices relative to the cost of attaining the same utility at base-year prices.

2. Chapter 3: Consumer Behavior 2 of 37 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. COST-OF-LIVING INDEXES 3.6 The initial budget constraint facing Sarah in 1995 is given by line l 1 ; her utility-maximizing combination of food and books is at point A on indifference curve U 1. Rachel requires a budget sufficient to purchase the food- book consumption bundle given by point B on line l 2 (and tangent to indifference curve U 1 ). Ideal Cost-of-Living Index TABLE 3.3 Ideal Cost-of-Living Index Price of books$20/book$100/bk Number of books156 Price of food$2.00/lb.$2.20/lb. Pounds of food100300 Expenditure$500$1260 2005 (Rachel)1995 (Sarah) Cost-of-Living Indexes Figure 3.23

3. Chapter 3: Consumer Behavior 3 of 37 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. COST-OF-LIVING INDEXES 3.6 A price index, which represents the cost of buying bundle A at current prices relative to the cost of bundle A at base-year prices, overstates the ideal cost- of-living index. Ideal Cost-of-Living Index TABLE 3.3 Ideal Cost-of-Living Index Price of books$20/book$100/bk Number of books156 Price of food$2.00/lb.$2.20/lb. Pounds of food100300 Expenditure$500$1260 2005 (Rachel)1995 (Sarah) Cost-of-Living Indexes Figure 3.23

4. Weighted Aggregate Price Indexes Paasche index q t = weighting percentage at q 0 = weighting percentage at time t base period p t = price in time period t p 0 = price in the base period Laspeyres index

5. Chapter 3: Consumer Behavior 5 of 37 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. COST-OF-LIVING INDEXES 3.6 Laspeyres Index ● Laspeyres price index Amount of money at current year prices that an individual requires to purchase a bundle of goods and services chosen in a base year divided by the cost of purchasing the same bundle at base-year prices. ● Paasche index Amount of money at current-year prices that an individual requires to purchase a current bundle of goods and services divided by the cost of purchasing the same bundle in a base year. Comparing Ideal Cost-of-Living and Laspeyres Indexes The Laspeyres index overcompensates Rachel for the higher cost of living, and the Laspeyres cost-of-living index is, therefore, greater than the ideal cost-of-living index. Comparing the Laspeyres and Paasche Indexes Just as the Laspeyres index will overstate the ideal cost of living, the Paasche will understate it because it assumes that the individual will buy the current year bundle in the base period. Paasche Index

6. Chapter 3: Consumer Behavior 6 of 37 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. COST-OF-LIVING INDEXES 3.6 ● fixed-weight index Cost-of-living index in which the quantities of goods and services remain unchanged. ● chain-weighted price index Cost-of-living index that accounts for changes in quantities of goods and services. Price Indexes in the United States: Chain Weighting A commission chaired by Stanford University professor Michael Boskin concluded that the CPI overstated inflation by approximately 1.1 percentage points—a significant amount given the relatively low rate of inflation in the United States in recent years. Approximately 0.4 percentage points of the 1.1-percentage-point bias was due to the failure of the Laspeyres price index to account for changes in the current year mix of consumption of the products in the base-year bundle.